Manage Volatility, Manage Risk

Know your costs, write a plan and execute it with discipline to manage risk and protect your hard-won assets. Economists' predictions that 2008 would be a tough year for pork producers turned out to be an understatement. The meltdown of the financial community and the resulting loss of investment funds in the commodity markets have made the situation even more dire for every American businessperson,

Donald M. Fedie Agri Control Co., Inc. Sioux Falls, SD | Mar 15, 2009

Economists' predictions that 2008 would be a tough year for pork producers turned out to be an understatement. The meltdown of the financial community and the resulting loss of investment funds in the commodity markets have made the situation even more dire for every American businessperson, including U.S. pork producers.

In effect, the financial stresses continue into 2009 because of the loss of credit and the losses of the investment community, which supplied massive funds to the futures trading of livestock, grains and crude oil, as well as other commodities, inside and out of agriculture.

We can be critical of Congress for having created the regulatory atmosphere that caused the sub-prime mortgage debacle, and in turn made massive amounts of investment dollars available to Wall Street and the commodities markets.

Still, to some extent, we should be thankful for the mountain of investment dollars, though the trading of grains and livestock became a mixed blessing for the American hog farmer.

Without the government mandate to produce and use ethanol and the availability of index funds money, corn would never have hit a high of almost $8/bu. Of course, one can rightfully argue that it never was worth $8/bu., because neither the hog farmer nor the ethanol producer could afford it.

As an offset, without the availability of the index investment funds, June (2009) hogs never would have hit $100/cwt., nor would all of the other opportunities to sell hogs at high prices been available.

All of these circumstances have set into motion a financial volatility that has engulfed not only the United States, but world markets as well. This volatility certainly has, does and will affect the profitability of hogs well into the future.

The extreme volatility is not just a flash-in-the-pan, and it's not going to end with a new administration in Washington.

To survive, we must all learn to live in a very volatile world, and that means doing a better job of managing risk.

In my 35 years of working with agricultural business clients, I have learned that the majority of producers are focused on the daily tasks of raising and caring for the well-being of their animals. Therefore, I try to apply that daily focus to risk management.

Many producers, including some of the largest, have chosen to manage marketing risk simply by having hogs for sale every week of the year. Some have even invested in a packing plant. Sadly, that often turns out to be a false interpretation of basic economics.

Marketing is Everything

The most important mantra for pork producers to learn is — marketing is absolutely everything.

Without a plan to assure your marketing objectives, it doesn't make sense to spend time and money on finishing a hog to 265 lb.

And, any attempt to control the cost of feed ingredients during a period of sharply rising prices is futile. Cost control requires a long-term approach and the use of commodity futures to offset rising prices.

With a good set of financial and performance figures, completing a plan is not that difficult, but a systematic approach is extremely important. The plan must include three fundamental factors:

Knowledge

Evaluate the risk present in your business. Know your costs (variable and fixed). Have a sound knowledge of the tools available and packer/investment community terminology.

Structure

Develop and complete a well-designed and structurally sound, written plan. Anticipate hog and grain price changes as much as 18 to 24 months into the future. Design a strategy to counteract any adverse volatility.

Discipline

Have the professional discipline to execute the plan as designed. Review the results. Keep records that will help make management decisions in the future.

Once you've spent the time, energy and money to develop a structurally sound business plan for managing the risk of marketing and price protection, there is always the nagging question about whether it will work.

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It works. In the case of marketing, there are few times when the price of cash hogs will be equal to a price that was available at some time during their finishing period. Waiting for high cash prices so often results in waiting in vain — and then, too often, the price taken is below the cost of production.

It's good business to price much of the growing pig population well in advance of the anticipated harvest date, as is illustrated in the June 2009 Chicago Mercantile Exchange (CME) futures chart (Figure 1[2]). With a price of $73, note how often, prior to Feb. 1, one could have sold hogs for more.

Using that as a reference, Figure 2[3] displays a database group of producers who have chosen to price hogs for 2009 sale, well in advance of monthly sales. The pricing information shown is as of December 2008 and includes both CME hedges and forward contracts with a packer. This clearly shows that the base group contracts are far better than the December 2008 CME price.

During a time when most hogs are selling for $30-40 under the cost of production, you must ask yourself what an additional $15-30/cwt. would mean to your long-term viability.

Certainly, I would not suggest that anyone pre-price 100% of their production — or even the majority of their production — at any one price. It is here that a disciplined approach to the incremental pricing of increasing percentages of potential hog sales can be established for each individual operator. A prudent and appropriate level of pre-pricing might be 40% for some, 85% for others.

Logically, one cannot protect corn at $4/bu. when it has already reached $7. Nor can you reserve soybean meal at $250/ton when it's selling for $400/ton.

Most producers heavily involved in day-to-day production details do not (or cannot) think about protecting grain to be used eight, 10 or 12 months later. That is why a written strategy is so important.

As the December 2008 corn charts (Figure 3[4]) illustrate, as a practical matter, corn used during 2008 should have been protected no later than May or June of 2007.

We convinced some of our clients to move forward after corn reached $4 in June, and most others when it reached $4.37 on Nov. 11. Was this soon enough? No, it wasn't, but it did achieve an average pricing of $4.86/bu. for the year.

For corn to be used this year, the March 2009 corn chart (Figure 4[5]) helps illustrate that the best time to start protecting corn was when it dropped to $5.29/bu. on Aug. 11, 2008, and after the 2008 challenge it happened. Since then, much of the corn has been protected at $3.40 to $3.60/bu.

As with pricing hogs, one needs to use a disciplined approach to the incremental pricing of percentages of total use at times when appropriate.

Don't Pass the Buck

We can be critical of our elected officials, the ethanol industry and others, but in the end, we must take a very hard look at our own actions — as pork producers and as businesspersons. Have we done everything possible to avert the catastrophes set in place these past 2½ years?

As a seasoned financial and management advisor to agriculture, I know that learning to address financial issues has been a real struggle. This is why the hog industry has lost some 50% of total cumulative equity during the past 1½ years. Many producers with a 65% equity position 1.5 years ago are trying to hold together a 30-35% equity position today — and hoping for a good 2009 to regain some of that borrowing power.

It is every producer's responsibility to be aware of current economic conditions and volatility. Wishing for a good year will not make it happen.

We are currently working with dairy, cattle-feeding and hog-feeding clients, and within that group are two hog producers who fit this discussion. Both noted that when June hogs hit $100/cwt., they were convinced prices would rise to $125/cwt. Today, after another six months of $35 to $40 cash live hog prices and the loss of $40/head sold, both are trying desperately to hold on until they can get refinanced. How tragic.

From “knowledge,” we concluded that nothing is forever, not even a rally in the hog futures, and if a profit is available, it should be exercised. In turn, a “structured” plan allowed us to capture what we could of the 2008 summer rally. And, “discipline” gave us the confidence to position our clients for some much-needed profit in 2009.

Donald M Fedie is president of Agri Control Co., Inc., a Sioux Falls, SD-based financial and management advisory firm specializing in agricultural business clients. Contact him at:[email protected][6]or (605) 367-9376.